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Despite the recent stock market pullback, the S&P 500 is still up just under 5% year to date on a total return basis. And, generally speaking, valuations of US stocks still look relatively expensive compared to historical averages, when measured by such metrics as the price-to-earnings (P/E) ratio.

In such an environment, it is as important as ever to do your research and use all of the tools at your disposal. Doing your fundamental research is always the first key step, but when it comes to assessing market sentiment, you might also consider adding a few indicators to your investing toolkit.

Here, we focus on 2 technical indicators: short interest for stocks and open interest for options.

Short interest is commonly expressed as a percentage—the number of shares sold short divided by the total number of outstanding shares. Suppose there are 10 total outstanding shares of a hypothetical stock. If one of those shares is sold short, the short interest as a percentage of outstanding shares will be 10% (1 ÷ 10 = 10%).

Short interest can also be applied to an index, such as the S&P 500, to provide a sense of bearish sentiment for the broad market. The short interest chart below demonstrates how short sellers have not become emboldened by the potential for a correction, even as stocks continue to march ever higher. Short interest did rise slightly in the first half of 2018, peaking in May, but quickly fell back to levels seen over the past several years.

Short selling levels continue to remain mostly stable.

Source: FactSet, as of October 11, 2018.

While you can get a general sense of investors who are bearish on the market using short interest as applied to an index, this measure is more commonly used for individual stocks. If a relatively large percentage of short interest exists relative to similar stocks or to the stock’s own historical levels, it may indicate that sentiment is generally pessimistic for the stock. For example, if stock A and stock B operate in the same industry, and stock A has short interest of 20% while stock B has short interest of 5%, based only on this indicator, market sentiment for stock A may be considered more bearish.

Why you might care about short interest

As with most technical indicators, this tool is not meant to be used in isolation. Rather, investors can use short interest to quickly compare sentiment between stocks.

Of course, the amount of short interest does not dictate how a stock will perform. Many companies that have a relatively high amount of short interest can exhibit positive returns.

Moreover, short interest can be a double-edged sword. Consider the so-called short squeeze, which occurs when the price of a stock with a relatively high amount of short interest increases at an unexpectedly fast pace. If the stock is consistently moving higher, and short sellers no longer believe it will decline in price, they may decide to cut their losses and close out their short positions by purchasing the stock. This action can result in temporarily “squeezing” the price higher.

If you have a short position (which is a risky strategy in and of itself because the potential loss is theoretically unlimited), the potential for a short squeeze is an even bigger risk to consider.

Many traders will also look at "days to cover" to evaluate a stock’s short interest. Days to cover is short interest divided by average daily volume. This can be important because it attempts to measure how long it may take to close out short positions and, consequently, the potential price impact of a short squeeze.

In sum, short interest can serve as another piece of information to assess a potential investment. You should not invest based solely on short interest; however, you can use it to help assess sentiment for a particular investment.

What is open interest?

For options investors, a useful tool to estimate volatility is open interest, which is the total number of options contracts that have not been exercised, closed out, or expired. This differs from volume in that open interest increases when a position is initiated and it decreases when the position is closed out; whereas volume will increase in both instances.

For example, suppose you bought a call option on the S&P 500 Index. This contract is now “open” and, consequently, open interest will increase. If you were to exercise that option one week from today, the contract would then be closed and open interest would decrease.

Meanwhile, volume would increase when you purchased the option and when you sold the option. Thus, you might think of open interest as a measure of active and open positions, and volume as reflecting total trading activity.

The Fidelity.com options screener (login required) can help you identify options with a certain level of open interest, including those in the Market Scanner provided by LiveVol, a third-party independent research company. This screen attempts to identify options with underlying securities that have open interest at least 300% above their historical average.

For example, here is a list of the top 10 stocks whose options have the highest percent average open interest that is at least 300% above their historical average, as of October 11, 2018:

News Corp (NWSA)

Liberty Oilfield Services (LBRT)

New Age Beverages (NBEV)

United Community Banks (UCBI)

Evoqua Water Technologies (AQUA)

Pyxus International (PYX)

Heritage Commerce (HTBK)

Red Lion Hotels (RLH)

Landec (LNDC)

Alliant Energy (LNT)

Why you might care about open interest

Open interest is particularly important for options traders, as it can help measure the potential future liquidity for a particular contract, as well as the potential volatility in the underlying asset. High open interest (and high volume) is a sign of strong liquidity—which is beneficial to options investors. Low open interest (and low volume) may be a sign of weak liquidity.

High open interest can also indicate the potential for volatility. If open interest were to suddenly spike, for instance, it might indicate investors’ belief in the potential for a short-term increase in the underlying stock’s volatility. The reason is that an increased amount of shares controlled by open options contracts might result in future price moves in the underlying stock—if the options are exercised.

Note that a sudden increase, or decrease, in open interest does not necessarily suggest which direction the stock might move. Rather, it may simply indicate there could be a change in the level of volatility. A change in the level of volatility could impact your decision to use different option-related strategies, such as choosing to establish long straddles and strangles for periods of expected high volatility, or butterflys and iron condors for periods of expected low volatility.

Still, some technical analysts think increasing open interest can be used to confirm an increase or decrease in the price of a stock or index. A rise in open interest coinciding with a rise in the price of a stock or index might be due to an increase in long positions (e.g., call options). This could be viewed by some as a bullish signal. Alternatively, if the price is moving higher or lower, but is not confirmed by an increase in open interest as well, that divergence could potentially be a signal that the bullish or bearish momentum may not continue.

To evaluate open interest, you can compare a current level of open interest to previous levels, or you might assess current open interest relative to the volume of contracts traded.

Investing implications

As with all investing endeavors, knowledge and information are essential. Knowing what these interest indicators are and how they can help you evaluate your investments may help improve your outcomes.

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Options trading entails significant risk and is not appropriate for all investors. Certain complex options strategies carry additional risk. Before trading options, please readCharacteristics and Risks of Standardized Options. Supporting documentation for any claims, if applicable, will be furnished upon request.

Any screenshots, charts, or company trading symbols mentioned are provided for illustrative purposes only and should not be considered an offer to sell, a solicitation of an offer to buy, or a recommendation for the security.

Technical analysis focuses on market action—specifically, volume and price. Technical analysis is only one approach to analyzing stocks. When considering which stocks to buy or sell, you should use the approach that you’re most comfortable with. As with all your investments, you must make your own determination as to whether an investment in any particular security or securities is right for you based on your investment objectives, risk tolerance, and financial situation.

There are additional costs associated with option strategies that call for multiple purchases and sales of options, such as spreads, straddles, and collars, as compared with a single option trade.

Stock markets are volatile and can fluctuate significantly in response to company, industry, political, regulatory, market, or economic developments. Investing in stock involves risks, including the loss of principal.

Past performance is no guarantee of future results.

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